"Perhaps the sentiments put forth here are not yet sufficiently fashionable to procure them general favor. A long habit of not thinking a thing wrong gives it a superficial appearance of being right, and raises at first a formidable outcry in defense of custom. But the tumult soon subsides. Time makes more converts than reason."
--Thomas Paine

Thursday, February 26, 2009

Really. We now know that no one likes paying taxes. The presumption was that Democrats liked taxes and that Republicans were opposed to them. But clearly that hypothesis was proven wrong. First, when the man who now sits atop the IRS, Tim Geithner, was nominated to be Treasury Secretary, it turned out that he preferred to not pay taxes.

But that failed to prove the point, as for many it was unclear whether Geithner was actually a Democrat. But Tom Daschle turned the trick. It finally was clear that Democrats, like Republicans, do not like to pay taxes.

Back in the day, taxes were not the issue. Spending was the issue. Back then, when everyone presumed that balancing budgets were among the sole tasks that our members of Congress were charged to perform––that and trashing the UN––Republicans liked to spend less and tax less. Democrats liked to spend more… and were somewhat agnostic on taxes. It was not that they liked taxes per se, but they were a necessary step to get to spend more.

Then Ronald Reagan changed everything, and all assumptions were cast to the wind. Since the Reagan Presidency, Republicans learned that spending really was not so bad, as long as taxes didn't have to pay for it. At first they voiced horror at the fiscal consequences of tax cuts, but, in time, they got over it.

And in time it really annoyed the hell out of Democrats. Ronald Reagan had led the Republican Party to the Promised Land. Cut taxes, spend money and let the chips fall where they may.

The premise was simple. It was unarguable. At any level of taxation, there is a lower level that will put more money back in the hands of taxpayers, and that will provide more resources for businesses to hire people and spur the economy onward.

It has become axiomatic. At every level of taxation, there is a lower level that if achieved will spur on the economy.

Therefore, following the logic to its natural conclusion, the optimal tax rate is zero.

Unless you need money. For stuff. Guns. Butter. You know. Stuff.

Or so we thought.

Today, we are approaching political Nirvana. In the final great leap of bipartisanship, the new administration is reaching for a new middle ground. Cut taxes in a nod to Republicans (and, it turns out, to everyone else, who also prefer to not pay taxes.) And increase spending. Because… Well. Because we can. Because we must.

And forget all those arguments about the expiring 2001 and 2003 Bush tax cuts. That is not a tax increase. That is just reality once again coming back to bite us.

Pardon the digression, but those tax cuts marked the beginning of the end of any integrity in tax policy. The scoring rules at the time required that tax legislation be budget neutral over a ten-year horizon. Congress was unable to pay for the tax cuts with other increases or spending cuts, so they paid for them by having them expire in year eight or so. So they complied with the ten-year scoring rules. Kind of. Lots of cuts for eight years. Lots of revenue to pay for them in years nine and ten.

Back in 2001, as they contemplated years of tax cuts that would suddenly expire, people jokingly referred to 2010 as “the year we push momma from the train,” because in 2011 the estate tax would rise dramatically back to its 2001 level. Well, here we are in year eight, and there is no need to worry about the estate tax. The estates were invested with Bernie Madoff.

Everyone gives lip service to debt being the problem that got us into our current mess. Not passing on to our children “a debt they cannot pay” was the great bi-partisan applause line of the President's speech the other night. They applaud fiscal responsibility. They just don’t believe in it. Or know what it is.

Look at the record over the past two decades. Our economic performance has been flat, other than the growth that we have literally purchased with debt. As a nation, we are like households whose real income has been flat for a decade, but who fund an increasing standard of living—new electronics, cruises, home improvements—through more and more borrowing. For years now, as a nation, our GDP growth has increasingly been purchased with imported capital.

Really.

Take a look at the new federal budget. $3.55 trillion of spending. A $1.75 trillion deficit. Maybe we have reached the tipping point. Finally, our revenues may become less than half our budget, and we can begin to migrate our tax rates to their optimal level.

Zero.

That does not mean we will have a 100% deficit. Far from it. We will still have cattle grazing fees.

And we will have the loan guarantee fees that the Federal Reserve charges for guaranteeing private debt. Those should be growing.

Twenty years or so ago, when my I was planning a move to California for a new job position, I listened to an interview regarding a study of the psychological affects of recessions on individuals and communities. Specifically, the study compared the incidence of mental illness, depression and suicide in Los Angeles during the recession there in the early 1980s with New Hampshire during the 1970s.

Apparently, mental illness, depression and suicide were more prevalent in southern California at the time than had been the case in New Hampshire during the previous decade. The study attributed much of the different experiences of the affected communities to differences in family and community structure. In New Hampshire, people continued to live in extended families and extended communities. During the economic downturn, older members of the community would tell stories about earlier recessions, and pass on the wisdom of the elders:

Economic cycles are part of life, like the seasons. Families need to cut back and save as the downturn approaches. During the downturn, workers need to be patient and improve their job skills. And, like the seasons, this is normal, and like a hard winter, this too will pass.

Los Angeles was a very different place, where people had moved to the new world of optimism and opportunity. But in the face of an economic downturn, the perspective of life and the economic seasons was lost. Instead, lacking the wisdom of the grandparents and elders in the community, the fear and pessimism that comes with job losses and economic decline was exacerbated and reinforced.

Over the past months, our country has responded to the recession with fear and pessimism that has been largely unchecked by an historical perspective on economic cycles. We have responded as Los Angeles responded, and the politicians and the pundits are exacerbating the fears expressed in conversations around kitchen tables, in beauty salons and at Starbucks.

Looking back, it is apparent that the depth and severity of our current economic downturn is due in large measure to the success of the Federal Reserve in forestalling significant periods of economic downturn for much of the past twenty-five years. We forgot—as individuals, as families and as businesses—that the economy is cyclical.

But even worse, we lost the value of periodic recessions as a cleansing and humbling time. For individuals and families, recessions are a time to take stock, to cut back on our materialist tendencies, to save, to pay down debts, to retool our skills. For businesses, recessions are a time to rethink strategy, to close marginal operations, and improve attention to costs and excess. For bankers, it is time to learn to write off bad debts and tighten up lending standards, and perhaps teach young associates the basic principle that when there are no profits, there are no bonuses.

In 1997, Foreign Affairs magazine published “The End of the Business Cycle,” trumpeting the success of the west in conquering the business cycle.

“Business cycles -- expansions and contractions across most sectors of an economy -- have come to be taken as a fact of life. But modern economies operate differently than nineteenth-century and early twentieth-century industrial economies. Changes in technology, ideology, employment, and finance, along with the globalization of production and consumption, have reduced the volatility of economic activity in the industrialized world. For both empirical and theoretical reasons, in advanced industrial economies the waves of the business cycle may be becoming more like ripples.”

Lost in the triumphalism of the article was recognition of the important role that periodic economic downturns play in stemming the exuberance, the hubris and the bad habits that build up during the expansionary phase of the economic cycle. For the past twenty-five years, the Federal Reserve has managed to forestall the regular economic downturns that previously characterized the post-war years. The dramatic increases in labor productivity that came about through computerization and changes in information technology, and the suppression of wage inflation that resulted from globalization and outsourcing, combined to suppress inflationary pressures.

As a result, the economy ploughed forward through crisis after crisis, through failure and fraud. The collapse of Continental Illinois. The savings and loan crisis. The bankruptcy of Drexel Burnham. The Asian financial crisis. The Russian financial crisis. The Internet bubble. The collapse of Long-Term Capital Management. September 11th. Enron. WorldCom. At each point of crisis or threat to the financial markets and investor confidence, the Fed was able to forestall downturns and spur continued economic growth by flooding liquidity into the system or pushing down interest rates, with little concern to the normal inflationary consequence.

Ten years later, in 2007, Business Week Chief Economist Michael Mandel articulated the new economic paradigm on his Economics Unbound blog.

“We now may be in a world of mini-recessions—sharp falls in one or two sectors which do not pull down the whole economy… A sharp drop in one sector—say, housing—may pull down a couple of adjacent sectors, such as furniture. But the rest of the economy steams on, and maybe even accelerates, as resources are transferred from the weak sectors to the strong sectors.

“This picture of the world actually fits very well with neoclassical economics. We may get a couple of quarters of negative GDP growth, but deep economy-wide recessions may be an anomaly rather than the norm.”

Now, we have learned that there is no new paradigm, and the business cycle is still with us. But this time, without periodic downturns to temper our exuberance and stem our excesses, we are paying a heavy price.

Consider this. Since Paul Volker stepped down as the Chairman of the Federal Reserve twenty years ago, median family income has increased ten percent in real terms. During that same period, household mortgage debt increased almost six-fold and consumer credit more than tripled, and financial institution debt grew more than eight-fold. Together, household and financial institution debt increased by over $24 trillion.

Even now, over a year into this financial crisis, we have yet to fully accept the depth of pain and dislocation that deleveraging may require. As we face the consequences of the boom years, we are going to need old wisdom as much as we need new policies. We are going to need to remain calm in the face of 24-hour cable shows playing on our fears and trumpeting every moment of our economic travails. Last night, President Obama tried to move beyond the position of policy wonk-in-chief, toward the role of the grandfather in New Hampshire. He scolded us for our excesses, while reminding us that the economy is cyclical and will rebound in time.

But what will we have learned when this moment is past? Will students of the Dismal Science no longer see the “end of the business cycle” as the Holy Grail of economic polity? Will we accept that the cycles of economic life are a necessary—and ultimately productive—check on human tendencies toward excess and exuberance? Or will we quickly fall prey to the hubris of policymakers and pundits who will as we ride the next wave, assure us that this time, once again, things will be different.

Saturday, February 21, 2009

This week, the Federal Deposit Insurance Corporation took over Silver Falls Bank in Silverton, Oregon. Silver Falls Bank was the 14th bank taken over by the FDIC this year. This compares with 25 banks that failed in 2008 and 3 in 2007. Bank failure is not unheard of. And up until a week or so ago, the term “nationalization” was not invoked.

Since its creation in 1933, the role of the FDIC has been to prevent runs on banks by insuring bank deposits and to oversee the orderly disposition of failed banks. For the better part of a century, it has done its job quietly and effectively. And today, we would all be well served to let the FDIC and its capable leader, Sheila Bair, do their job.

From the beginning of the current financial crisis, one of the problems has been the failure of the leading agents of the government, embodied by Hank Paulson and Ben Bernanke, to establish clear rules and follow them. Instead, we have plodded along, from crisis point to crisis point. From Bear Stearns to Fannie Mae to Merrill Lynch to Lehman Brothers to AIG to Washington Mutual, each collapse engendered a unique response by the Treasury and the Federal Reserve.

In a similar manner, the focus of the $700 billion Toxic Asset Relief Program—the federal bailout—to address the insolvency of the nation’s largest banks has veered from the purchase of toxic assets to injections of capital to guaranteeing of assets. Now once again, toxic asset purchases are back in vogue as the strategy of choice, this time under the “good bank, bad bank rubric.”

This week, the stock market broke through its technical support levels, and now appears headed toward 6,000 as its next support level. Some observers have suggested that the decline reflected the market response to looming plans for the “nationalization” of the banking system and one more step down the road to socialism, as trumpeted on the cover of Newsweek.

But market decline was not a result of the fear of nationalization, and nationalization would not mark the next milestone on the road to socialism. Quite the contrary. Investors are running away from banks—good banks and bad banks alike—precisely because the federal efforts to date have obscured the true financial condition of the banks. Faced with uncertainty and poor information, investors will always pull back and wait for the fog to clear.

The takeover of insolvent banks by the FDIC is the way the process is supposed to work, and the way it has always been allowed to work—up until now. For all of the debates over the “Swedish Model”—where banks were taken over, balance sheets reconfigured, and then spun back out to private ownership—the way they did it in Sweden is not actually all that different from the way they do it at the FDIC, when the FDIC is allowed to do its job. Insolvent banks are seized. Assets are sold off and the depositors are paid or, if possible, the balance sheet is cleaned up and the bank is sold off to a new owner.

The problem today is that a small number of our insolvent banks, notably Citi, are very big and very visible. But the problems they face are the problems that the FDIC was created to fix. This is not nationalization, it is essentially a debtor-in-possession bankruptcy process whereby the FDIC serves as the receiver.

If left to do its job, the FDIC would do what the banks resolutely refuse to do: sell their bad assets, accept the price of their business decisions, and move on. The banks refuse to do it because it would force them to face up to what the markets, and increasingly outraged taxpayers, have known for a while: They are insolvent.

For years, America has told other countries how to deal with financial crises: Cut your losses. Clean up your balance sheets. Get on with it.

This week, the stock market said the same thing.

On a side note, the Ford Motor Company—the one that is not taking federal money—has seen its market share rise steadily for the past four months. This is the way markets are supposed to work. Saving one company or another—or one bank or another—is not an inherent public good, however politically compelling. And pumping public money into one company serves to dramatically disadvantage their competitors.

One of the biggest mistakes that Hank Paulson made was demanding that banks take TARP money, even if they didn’t want to—or need to—in order to remove the stigma from those who did. Somehow, this was supposed to be a way of maintaining confidence in the system. But instead of protecting the bad banks, by letting them hide among the good, it has achieved the opposite. That is why investors have turned their back and are walking away.

The banking industry and the markets would be better served if the politicians and the pundits quieted their politically loaded hubris about nationalization, and if the Treasury and the Fed let the process work, as it has been designed to work. Forget about creating good banks and bad banks. Let insolvent banks take their medicine. Management, shareholders and bondholders will pay a steep price for business failure. And let the banks that are healthy take market share from those that are not.

It is time to let the process work. Punish failure. Reward success. This is not nationalization, it is the way the system is designed to work. Time to take the banks off the dole, and let Sheila Bair do her job.

Saturday, February 07, 2009

It needs to be said: The Congress of the United States has no business setting the terms of executive compensation. That is not how capitalism is supposed to work.

But then again, the US Government has no business giving tens of billions of dollars to corporations, and getting nothing in return but a hope and a prayer. That is not how capitalism is supposed to work, either.

Take Citi. This Thursday, the market value of Citigroup––the icon of the American banking establishment––was $18.3 billion. That is to say, at least according to the old school rules, that for $18.3 billion, you could purchase all of the common stock of the company. For something less than that, you could purchase enough shares to control the Board of Directors.

Yet, over the past few months, the US Government has invested $50 billion in Citi. In the parlance of the venture capital world, we invested $50 billion in a company, and the “post-money” value is $18.3 billion. Suffice it to say that the “pre-money” value––the value of the company before the infusion of new capital––was a big negative number.

By any normal measure, Citi was insolvent. The common equity was worthless, but for the infusion of public money. So, all of the arguments of nationalization are somewhat academic. The federal government did not wipe out the common equity holders, the market did. If there is market value remaining, it exists only at the sufferance of the US taxpayers. The only question is what how the government should be asserting its rights and privileges.

In a normal world, an investor who bails out an insolvent company takes control of the board of directors––by one means or another. And any appropriate controls on executive compensation––on bonuses and the like––are subject to the control of the board, as they are in any corporation. But what seems to be broken in all that has transpired over the past few years, is that the fundamental concept of board control and corporate governance.

The notion is simple. A corporation is a company owned by stockholders. The stockholders elect a board of directors to serve their interests in the governance of the company. The board hires and fires the chief executive and the management team, sets compensation, and establishes corporate policy and the like.

But little has been spoken about the boards of the great American financial institutions that have brought the world economy to its knees. Sure, Robert Rubin has been silenced for his complicity as a member of the board of directors of Citigroup. But little has been said about the more fundamental issues, conflicts and failure of corporate governance that have occurred on our long march toward the abyss.

Richard Fuld, the CEO of Lehman Brothers, who demonstrated an astonishing lack of imagination as he sat before Congress and suggested that, even in the wake of the financial collapse, he could not think of a single thing that he would have done differently if he could do it all over again. Fuld served as both Chairman and CEO of Lehman Brothers, a not uncommon situation in corporate America where a CEO effectively reports to him or her self, evaluates his or her own performance and sets his or her own compensation.

If Lehman had been a partnership––as it was for most of its corporate existence––perhaps this conflict would be acceptable. But for a publicly traded company, this relationship violates one of the central tenets of corporate governance: That the CEO is accountable to the board of directors, and that the directors represent the interests of the stockholders.

AIG further illustrates the problem of the failure of board oversight. The collapse of AIG was directly a result of the company’s failure to understand the risks related to its burgeoning credit default swap business. The profits of the global insurance giant became increasingly tied to its credit derivatives business, run by Joseph Cassano, the head of AIG Financial Products. Yet even as Cassano represented that there was no risk of AIG losing “a single dollar” on any of its credit default swap transactions, no one on the board managed to ask the simple question of why sophisticated financial institutions––the counterparties on the other side of those transactions––would willingly pay AIG billions of dollars annually, if there was no risk of loss. Presuming that all of those sophisticated counterparties were not fools, a board member might have asked, how can that be?

Looking back over years of financial crisis and collapse, and one common thread has been the failure of board governance of public companies. The savings and loan debacle. The collapse of Drexel Burnham Lambert. Enron. Each was characterized by boards who had lost site of their central purpose: To hire and fire the CEO, set corporate policy, and serve the shareholder interests.

Congress should take no action to set the terms of executive compensation. The problem that needs to be fixed is more fundamental: The failure of the fundamental governance structure of public companies. In the investment banking world––in the world of risk––perhaps it is time to return to partnerships and assure that when capital is at risk, people are too. But the days of the cozy, insider boards needs to end. The cost––to the shareholders and the public alike––is too high.

Whether or not the Treasury controls the boards of directors in companies where the common equity has been functionally wiped out is not the salient question, though certainly there is not a true capitalist in the country who would debate whether after a $50 billion investment into a $18.3 billion company, anyone but the US Treasury is entitled to control. The question is how board accountability and responsibility should be reestablished––both for the recipients of TARP funds and across the corporate landscape.